The market is hitting new multi-years highs and investors are flocking back in. All the new found euphoria represents a danger signal to me. Simply put the tendency is to accept excessive risk exactly at the wrong time in the market. When the exact top in the market will occur is unknown, but what we do know is that we are probably much closer to the top than we are to the bottom. So at this juncture it is more important than ever to pay attention to managing your portfolio for risk.
When you trade options it is not so important to look at the returns you are getting. In fact it is fairly easy to make good returns by selling options. Time is guaranteed to pass and theta burn will make you money. The real secret is not giving it back. Controlling risk is a paramount concern for any option trader. When we sell options it is typical for the expected return to be relatively small but the possible loss may be much larger.
Most of the option strategies I use in a bull market are oriented toward selling out of the money puts at the heart of the strategy. This naturally captures a small amount of premium but creates the possibility of a low probability larger loss.
When presented with the likelihood of many small wins and a few larger losses the best thing is to maintain many small positions of roughly equal size. The basic idea is to cover the larger losses with many small wins. That way most months are winning months. More importantly, you avoid the possibility that a single large loss in a big position can wipe you out.
The strategy I recommend is to decide how many positions you can manage. For me the number is 40. For active traders it might be 20. If you have a day job that keeps you away from a computer it might be only 10.
The most important thing is to keep a cash cushion. Selling options exposes you to the risk of an increase in margin requirements. It also exposes you to the risk of an assignment. Having a cash cushion of 20% of your portfolio allows you to suffer unplanned events such as the two just mentioned.
To put it all together allocate 20% of your portfolio to a cash cushion. The remaining 80% should be allocated to equal sized positions. The allocation should be based on the margin required for each position. In other words the margin should be equally spread around.
If you follow these guidelines the returns will happen on a consistent basis. But the key is that the risks will even out and you will be able to trade on a more consistent basis. This is especially important with the market at new highs to reduce your risk.
OptionsProfits can be followed on Twitter at twitter.com/OptionsProfits.
EXCLUSIVE OFFER: Jim Cramer's Protégé, Dave Peltier, only buys Stocks Under $10 that he thinks could potentially double. See what he's trading today with a 14-day FREE pass.
Select the service that is right for you!COMPARE ALL SERVICES
- $2.5+ million portfolio
- Large-cap and dividend focus
- Intraday trade alerts from Cramer
- Weekly roundups
Access the tool that DOMINATES the Russell 2000 and the S&P 500.
- Buy, hold, or sell recommendations for over 4,300 stocks
- Unlimited research reports on your favorite stocks
- A custom stock screener
- Upgrade/downgrade alerts
- Diversified model portfolio of dividend stocks
- Alerts when market news affect the portfolio
- Bi-weekly updates with exact steps to take - BUY, HOLD, SELL
All of Real Money, plus 15 more of Wall Street's sharpest minds delivering actionable trading ideas, a comprehensive look at the market, and fundamental and technical analysis.
- Real Money + Doug Kass Plus 15 more Wall Street Pros
- Intraday commentary & news
- Ultra-actionable trading ideas